Daily Archives: April 19, 2011

“Although we believe these strengths currently outweigh what we consider to be the U.S.’s meaningful economic and fiscal risks and large external debtor position, we now believe that they might not fully offset the credit risks over the next two years at the ‘AAA’ level,” said Standard & Poor’s credit analyst Nikola G. Swann. […] “Our negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years,” Mr. Swann said.

So the credit risk of the US is potentially growing according to S&P so it threatens to downgrade the US credit rating. In order to understand how S&P arrived to this conclusion let’s have a look at how credit risk is defined in its 2007 sovereign debt primer:

QUOTE 1: “A sovereign rating is a forward-looking estimate of default probability. […] The key determinants of credit risk [are economic risk and political risk]. Economic risk addresses the government’s ability to repay its obligations on time and is a function of both quantitative and qualitative factors. Political risk addresses the sovereign’s willingness to repay debt. Willingness to pay is a qualitative issue that distinguishes sovereigns from most other types of issuers. Partly because creditors have only limited legal redress, a government can (and sometimes does) default selectively on its obligations, even when it possesses the financial capacity for timely debt service.”

S&P has two ratings, a local currency rating (default risk on domestic-currency-denominated debt) and a foreign currency rating (default risk on foreign-currency-denominated debt). The primer notes:

QUOTE 2: “A sovereign government’s ability and willingness to service local currency debt are supported by its taxation powers and its ability to control the domestic monetary and financial systems, which give it potentially unlimited access to local currency resources. To service foreign currency debt, however, the sovereign must secure foreign exchange, usually by purchasing it in the currency markets. This can be a binding constraint, as reflected in the higher frequency of foreign than local currency debt default. The primary focus of Standard & Poor’s local currency credit analysis is on the government’s economic strategy, particularly its fiscal and monetary policies, as well as on its plans for privatization, other microeconomic reform, and additional factors likely to support or erode incentives for timely debt service. When assessing the default risk on foreign currency debt, Standard & Poor’s places more weight on the impact of these same factors on the balance of payments and external liquidity, and on the magnitude and characteristics of the external debt burden.”

S&P provides a table that shows the number of defaults on foreign-denominated sovereign debt and notes that: “Defaults on sovereign foreign currency bonds occurred repeatedly, and on a substantial scale, throughout the 19th century and as recently as the 1940s.” Interestingly, however, it does not provide such a table for the domestic-denominated sovereign debt. The primer continues by noting:

QUOTE 3: “One might ask why, if sovereigns have such extensive powers within their own borders—including the ability to print money—sovereign local currency ratings are not all ‘AAA’. The reason is that while the ability to print local currency gives the sovereign, and the sovereign alone, tremendous flexibility, heavy reliance upon such an expansionary monetary stance may bring the risk of hyperinflation and of more serious political and economic damage than would a rescheduling of local currency debt. In such instances, sovereigns may opt to reschedule their local currency obligations.”

There are two type of sovereign debt: Domestic-currency denominated and foreign-currency denominated

Governments that can tax and issue their own currency have the full capacity to pay domestic-currency-denominated debt

Inflation risk is a form of default risk

Now let’s look if all this makes sense in the case of the US. First, note that the US is a monetarily sovereign country: the federal government issues its own currency, the federal government has no foreign-denominated debts outstanding, and the federal government does not peg its currency in anyways (and so does not promise to convert US dollars into another currency or gold on demand). This means that the US federal government can always meet payments that are due to its creditors anytime (today or in the future) and anywhere (in the US or abroad) by crediting bank accounts. Stated alternatively, there is NO possible risk of default for economic/technical reasons. The federal government cannot run out of money, it has a perfect capacity to pay: economic risk is zero.

The problem with S&P is that it has a shifting definition of economic risk. As quote 3shows, S&P is aware of the absence of economic risk in the case of the US but it proceeds to argue that there is one by changing the definition of default risk to include risk of hyperinflation. OK…hold on… are we talking about default or inflation risk? These are two completely different risks.

In terms of default risk, higher inflation (if revenues of borrowers are indexed to it) increases the capacity of repayment and so LOWERS default risk rather than increases it. If, following S&P’s logic in quote 2, one considers taxes a form of revenues that helps to pay debt, then tax revenues rise with inflation and so lower the risk of default.

In terms of inflation risk, inflation pressures on the demand side are very low and the risk of uncontrollable hyperinflation that S&P refers to in quote 3… give me a break! But there is a deeper misconception at play. S&P (and all politicians in Washington) seems to think that they have some meaningful control over the fiscal balance of the federal government. They do not; as the UK experience, among others, is painfully showing us. The fiscal balance of the government is ultimately driven by the net saving of the private domestic sector and of the rest of the world, as was explained many times on this blog. The following identity holds at the aggregate level:

Stated alternatively, the US government must deficit spend currently and in the near future in order for the private sector to repay its outstanding debt and for foreigners to accumulate dollars. It is only if the private sector as a whole decides to dissave (spends more than what it earns) and/or foreigners decide to dissave (import more than they export to the US) that the government can lower its deficit and potentially run a surplus. Any attempts to go against the desires of the two sectors will lead to a recession. The deficit will go down by itself as the private and foreign sector gain confidence and decrease their net saving.

By conflating inflation risk and default risk in their rating, S&P (and probably other CRAs) creates confusions in financial markets and promotes dangerous ideas. Sounds familiar? Remember all those toxic mortgage products that were rated AAA? One more time, S&P is showing how silly it is to extend a rating methodology that was developed for corporate bonds to other sectors of the economy. Even for corporate bonds, results are far from perfect (remember all those financial institutions that had an AAA rating or so right before they failed?)

So overall there is zero default risk due to economic risk in the US, as an issuer of the currency in which sovereign debt is denominated, the US (like the UK and Japan but contrary to Eurozone countries) can always repay dollar-denominated debts it issued. But what about credit risk due to political risk, i.e. unwillingness to pay?

First and foremost, cases of voluntary default by a monetarily sovereign government on its domestic-currency-denominated date are extremely rare. Following Rogoff and Reinhart, it looks like Japan is a candidate in 1942, a very unusual political and economic situation (and probably a means to limit inflationary pressures by not adding purchasing power to the private sector, so default could be a good policy). It is hard to detect more countries given that the authors do not give us any background about the monetary system at the time of default. The US is not experiencing any massive war exhausting its resources (even that is not enough to increase the risk much), its political system is stable, and Geithner has told us many times that the debt ceiling will be raised that any chance of political problem is at best remote. True, the Congress may tie its own hands and decide not to raise the debt limit, but how realistic is that possibility?

Bottom line, credit risk is remotely remote. You have more chance to be hit by lightening twice during your life than to experience a default of dollar-denominated sovereign US debt. The only really worrisome variable is the stupidity of US congress and its willingness to try to fix something that is not broken. People love Medicare (by far the most popular program of the government), they love social security, and automatic stabilizers are working as predicted. Let them be.

In the Savings and Loan (S&L) debacle Speaker Wright became enraged at the Federal Home Loan Bank Board and the Department of Justice when he learned that the FBI was investigating 400 individuals, most of them Texans, for their possible role in the S&L control frauds that were causing the regional bubble in commercial real estate (CRE) to hyper-inflate. (Akerlof & Romer’s 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit” discussed the major contribution the S&L frauds made to expanding that regional bubble.) Legend has it that an FBI agent accidentally left the list of investigative targets with an interviewee who copied it. Whatever the truth of the legend, Speaker Wright eventually reviewed a copy of the list and noticed that it had the names of many contributors to the Democratic Party. He and several senior Democratic colleagues and a staffer responded to the list by dividing up telephone calls to the FBI, Justice Department and the Federal Home Loan Bank Board (Bank Board). Wright was enraged and concluded immediately that the investigation was politically motivated. He wanted the investigation killed.

Wright began intervening with the Bank Board on behalf of a series of Texas S&L control frauds in 1986 and 1987. He eventually held the bill to “recapitalize” the Federal Savings and Loan Insurance Corporation (FSLIC) (the “FSLIC recap” bill) hostage to extort more favorable regulatory treatment for these frauds’ CEOs. Wright’s extortion focused on preventing agency actions against three Texas executives. Each of the executives shared two traits – they had voted for President Reagan in 1980 and they were now contributing to the Democratic Party. When we met with Speaker Wright in early 1987 his primary argument was the extreme fragility of Texas’ economy. (The meeting was set up by Bob Strauss, the grand old man of Texas Democrats, as a “peace meeting.”) I was the agency’s “point man” seeking to get FSLIC recap passed. The meeting was a disaster, Wright ended up claiming (incorrectly) that the head of our agency had lied to him and let loose in a swearing tirade aimed at me. What Wright never understood was that the most politically active Texas S&Ls were so active because they were frauds and desperately needed protection from being closed by us. In particular, we intended to use the additional funds we would receive under FSLIC recap to close the worst control frauds and those frauds were located primarily in the states with the weakest regulation and supervision. Texas was the most criminogenic environment because it had the earliest extensive deregulation and the most complete state desupervision. (The top State of Texas S&L regulator later admitted to using prostitutes provided by Vernon Savings (aka “Vermin)). Vernon was the second worst control fraud in the nation and had 96% of its loans in default when it was finally placed in receivership despite Wright’s extortion. We had been so aggressive in closing the control frauds that by early 2007 we had roughly $500 million in the FSLIC fund – to insure an (insolvent) industry with $1 trillion in liabilities. We were running on fumes. Wright knew this and knew that holding the FSLIC recap bill hostage would give him exceptional leverage over our agency. Unfortunately for Wright, the result of the failed peace meeting was that we were able to convince the head of our agency that we had to take on Speaker Wright rather than continuing to capitulate to his ever increasing extortion. Doubly unfortunately, I was assigned the task of explaining to the public how the Speaker was extorting us on behalf of frauds and endangering the public. Thereafter, he tried repeatedly to get me fired. (One of the proposed ethic charges by the independent counsel for the House ethics committee investigating Speaker Wright was those attempts.)

Speaker Wright cultivated an image designed to terrorize opponents. He was nasty, asking us to fire our top supervisor in the Texas region on the “grounds” that he Wright had heard he was a homosexual. Wright had exceptional leverage over us because we were desperately short of funds and he held our access to funds hostage. Our agency (over several of our objections) gave in to many of his demands, including terminating a civil suit against a lender who had defaulted on his debts to roughly a dozen S&Ls. At no time, however, did we even consider giving in to Speaker Wright’s desire that we back off of criminal referrals, investigations, or prosecutions.

Later, under Bank Board Chairman Danny Wall, the agency’s head of enforcement wrote a “side letter” promising Charles Keating’s Lincoln Savings that the agency had no present intention of filing additional criminal referrals. (We, the Federal Home Loan Bank of San Francisco (FHLBSF), had filed criminal referrals based on the findings of a formal investigation that established that Lincoln Savings had forged thousands of signatures and scores of documents and had stuffed the files with purported underwriting files. Those files were actually created by Arthur Andersen years after the junk bonds were purchased for the sole purpose of deceiving the examiners into believing that the S&L had underwritten the bonds before purchasing them.) The FHLBSF had discovered evidence of additional likely crimes by Lincoln Savings, but had not completed the referrals, at the time the “side letter” was written. Danny Wall and Bank Board member Roger Martin removed our (the FHLBSF’s) jurisdiction over Lincoln Savings (an unprecedented act) because we refused to withdraw our recommendation that Lincoln Savings be placed in conservatorship despite the political intervention of the five U.S. Senators who became known as the “Keating Five” and Speaker Wright on behalf of Keating. The Bank Board made no criminal referrals against Lincoln Savings after it removed our jurisdiction despite finding new evidence of likely fraud. The FHLBSF was not informed of the existence of the side letter and while the deal documents detailing the Bank Board’s de facto surrender to Keating were provided to us the side letter was not. I learned accidentally about the existence of the side letter in preparing for the House hearings on the scandal of the successful political intervention on behalf of Keating – the most notorious S&L control fraud. I then exposed the side letter and its import in my testimony. The side letter sealed Danny Wall’s fate. The Committee, on a bipartisan basis, was outraged by it. Wall resigned in disgrace.

I set forth this history because of the disclosures in Gretchen Morgenson and Louise Story’s April 14 article in the New York Times “In Financial Crisis, No Prosecutions of Top Figures.”

Morgenson and Story’s reporting revealed that Timothy Geithner discouraged criminal investigations of suspected accounting control frauds. I was asked to comment on this “elite felons go free” policy by Kai Ryssdal, Marketplace’s business journalist.

Ryssdal: What about the argument, though, that the financial system is so fragile still, and these cases so complicated, that we can’t really tear things apart with substantive investigations and prosecutions because it will all fall apart again?

Black: Yeah, that’s an excellent point. We should leave felons in charge of our largest financial institutions as a means of achieving financial stability.

When more junior officials took actions discouraging criminal investigations against Charles Keating that were considerably less harmful than Geithner’s actions the Congress, the administration, and the media treated those actions as infamous and the head of the Office of Thrift Supervision, Danny Wall, had to resign. Why aren’t Geithner’s and Holder’s far more harmful and unprincipled actions, and failures to act, with regard to the elite criminals that caused the Great Recession a national scandal? Why isn’t Attorney General Mukasey, who was even more derelict than Holder, considered a national embarrassment? Have we lost our capacity as a nation for outrage? Are these elite ethical failures too powerful to hold accountable?